Valuation of IR Derivatives in a new Regulatory Environment

Speakers:

Eduardo Pereira Risk and Regulation Specialist: Bloomberg L.PBernardo Santos Andrade Senior Manager, Toyota Motor Finance (Netherlands) B.V

Dutch Association of Corporate Treasurers Event: Hotels Van Oranje, Noordwijk, The Netherlands.

11th November 2013.

Agenda

• OIS Discounting: A new valuation framework;• CSA Agreements;• CVA;• CSA Agreements – Bloomberg ‘MARS’ solution;• TMFNL: Collateral Operation Case Study.

OIS Discounting

• Prior to Credit Crisis credit & liquidity effects were largely ignored in IR derivatives pricing

• Subsequent to Credit Crisis – Stronger Focus on Counterparty Risk (Credit)

• Evaluating Exposure• Risk Management

– Stronger Focus on Funding (Liquidity)• Divergence between “risk free” rates and funding levels• Funding arbitrage opportunities

• New framework required as credit & liquidity effects can no longer be ignored in pricing

Overview of OIS Framework

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Swap Value

• IR swaps can have both negative or positive values

• If market value is positiveÞ Counterparty owes moneyAnd if counterparty defaultsÞ Loss for everything that can’t be recovered........

• Credit mitigation very important• Changes in Regulation

Þ Banks to be penalised for uncollateralised swaps

Counterparty Risk

• Mitigating credit exposure (interbank)– Netting Agreements– Credit Support Annex (CSA) agreement– Central Counterparty (CCP) clearing

• CSA: Collateral posted between counterparties• CCP (e.g. LCH.Clearnet): “Variation Margin” paid

(or received) each day by clearing member (in addition to “Initial margin”)

• Both CSAs & CCP define how interest accrues on funds (collateral or margin payments)

Swaps in the Interbank Market

Credit & Liquidity Premium in Euribor

LOIS EUR <GO>

Credit & Liquidity Premium in Euribor

Credit Crunch: Market First Fears

Credit & Liquidity Premium in Euribor

Bear Stearns ‘Bailout’

Credit & Liquidity Premium in Euribor

Lehman Bankruptcy

Credit & Liquidity Premium in Euribor

Ireland Crisis

• IR swaps can have both negative or positive values• If market value is positive

Þ Counterparty owes moneyAnd if counterparty defaultsÞ Loss for everything that can’t be recovered........

• Credit mitigation very important• Banks generally have agreements to post collateral to each

other– Credit Support Annex (CSA) agreement – Central Counterparty Clearing (CCC)

• Generally corporates do not wish to sign CSAs or agree to CCCsÞ Both parties exposed to counterparty risk

Counterparty Risk

Counterparty Valuation Adjustments

For a swap how do you currently determine what you are being charged for your credit risk?

• By using the Bloomberg CVA/DVA calculator • My relationship banks provide full disclosure

on these charges • Unaware of any such charges • We calculate using other methods • We do not get charged

Webinar Poll 2 - Question

16%

33%

24%

23%5%

Responses: 106

Bloomberg CalculatorFull disclosureUnawareOther MethodsNot charged

Webinar Poll 2 Results

Calculating Credit Spreads

CVA/DVA Calculator

Calculating Credit Spreads

Calculate Exposure from Counterparties Perspective

Calculating Credit Spreads

Market Information: Credit, Rates & Volatility

Calculating Credit Spreads

DVA: Cost to Bank of Corporate Defaulting

Calculating Credit Spreads

CVA Calculation: Cost to Corporate of Bank Defaulting

Calculating Credit Spreads

Bilateral Calculation

Exposure Graph

Bilateral Calculation

Charting Net Cash Flows

Net Cash Flows affect Exposures